I am a Tax Partner in WithumSmith+Brown’s National Tax Service Group and the founding father of the firm's Aspen, Colorado office. I am a CPA licensed in Colorado and New Jersey, and hold a Masters in Taxation from the University of Denver. My specialty is corporate and partnership taxation, with an emphasis on complex mergers and acquisitions structuring. In the past year, I co-authored CCH's "CCH Expert Treatise Library: Corporations Filing Consolidated Returns," was awarded the Tax Adviser's "Best Article Award" for a piece titled "S Corporation Shareholder Compensation: How Much is Enough?" and was named to the CPA Practice Advisor's "40 Under 40."

In my free time, I enjoy driving around in a van with my dog Maci, solving mysteries. I have been known to finish the New York Times Sunday crossword puzzle in less than 7 minutes, only to go back and do it again using only synonyms. I invented wool, but am so modest I allow sheep to take the credit. Dabbling in the culinary arts, I have won every Chili Cook-Off I ever entered, and several I haven’t. Lastly, and perhaps most notably, I once sang the national anthem at a World Series baseball game, though I was not in the vicinity of the microphone at the time.

Tough day today. Your son got suspended for hosting an underground craps game at recess. Your husband spent the money you set aside for health insurance on magic beans. And you just wasted 45 maddening minutes trying to walk your elderly father through how to use Skype. But as bad as things may have seemed for you and your family, I assure you, it could have been a lot worse. You could have been that clan from Pennsylvania who walked out of Tax Court $30 million in the hole this afternoon.

In R. Ball v. Commissioner, T.C. Memo 2013-39, a Pennsylvania family formed a number of trusts who in turn owned stock in an S corporation. The S corporation, in turn, owned stock in a C corporation. In 2003, the S corporation made a qualified subchapter S subsidiary (QSub) election to disregard the C corporation’s separate existence and treat it as a division, and the shareholders increased their basis in the S corporation stock by $226 million to account for the appreciation inherent in the S corporation’s assets. Weeks later, the shareholders sold the stock in the S corporation for $230 million, and after comparing the purchase price to their newly increased stock basis, reported losses on their 2003 tax return.

The IRS denied the $226 million basis increase upon the making of the QSub election, and determined that rather than losses, the shareholders recognize $215 million of gain on the sale of their S corporation stock.

This left the court to decide whether a QSub election and the subsequent deemed liquidation results in an increase in the shareholder’s basis in the parent corporation’s stock.

Using numbers to illustrate the issue, let’s assume the shareholders originally had a basis in their S corporation stock of $15 million. At that point, the S corporation made a QSub election for its wholly-owned C corporation subsidiary, which had assets worth $240 million and a tax basis in those assets of $14 million. Upon the making of the QSub election, could the shareholders of the S corporation increase their basis in the S corporation’s stock from $15 million to $241 million to reflect the $226 million of gain inherent in the C corporation’s assets at the time of the QSub election?

To understand how the Tax Court approached this issue, and why it’s an important analysis, we have to understand some basic concepts that span Subchapters C and S:

1. In general, S corporations do not pay entity level tax. Instead, under Section 1366(a)(1), each shareholder reports their pro rata share of income or loss on their individual income tax return. To prevent double taxation, shareholders are required to increase their basis in the S corporation stock by income and decrease it by losses, distributions, and nondeductible expenses.

3. Included in the positive adjustment to stock basis is an increase for tax-exempt income realized by the S corporation. Why is this? To preserve the tax-exempt nature of the income. Assume you put $100 into S Co. which S Co. invested in muni bonds, generating $20 of tax-exempt interest under Section 103. If someone wanted to buy your stock, they would likely pay $120 for it. If you did not increase your stock basis from $100 to $120 upon pass-through of the $20 of tax-exempt income, the $20 of tax-exempt interest would effectively be taxed upon the sale of the stock.

4. Under Section 1361(b)(3), an S corporation may elect to treat a 100% owned subsidiary meeting certain requirements as a QSub, in which case the subsidiary’s tax existence is disregarded and the assets and liabilities of the subsidiary are deemed to be owned by the parent.

5. The regulations provide that when a QSub election is made, it results in a deemed liquidation of the subsidiary under Sections 332 and 337.

6. Under these two code sections, the liquidation of a 100% subsidiary is not a taxable event. The parent corporation merely takes a basis in the assets of the subsidiary equal to the subsidiary’s basis prior to liquidation. The subsidiary does not recognize gain on the distribution of any appreciated assets to the parent, which is an exception to the general rule of Section 311(b) that treats a corporate distribution of appreciated assets as a sale. Likewise, the parent recognizes no gain upon receipt of the subsidiary’s assets.

Got all that? Good.

In Ball, the taxpayer argued that when the parent made the QSub election (#4 above) and liquidated the subsidiary (#5), since the subsidiary did not recognize gain on the appreciation inherent in its assets under Section 337 (#6), the unrecognized gain should be treated as tax-exempt income earned by the subsidiary, passed through to the parent corporation, and in turn passed through to the shareholders. As a result, the shareholders should increase their basis in the parent corporation’s stock (#3).

The IRS and Tax Court disagreed. The court reasoned that Section 337 is not an exemption from income, but rather a nonrecognition provision that simply effects a change in the form of a taxpayer’s property. In this case, the parent S corporation continued its investment in the subsidiary corporation, but in a different form by holding the assets directly rather than through stock ownership.

The court differentiated this situation from one in which an S corporation recognizes cancellation of indebtedness income that is excluded under Section 108, which was held by the Supreme Court in Gitlitz to increase the shareholder’s basis in the S corporation. In the COD context, the taxpayer has realized a clear accession of wealth by being relieved of a debt that is then being excluded under a statutory provision.

When a corporation liquidates its subsidiary, however, the combined companies are no wealthier than they were before. The court thus concluded that “tax-exempt income” for purposes of increasing a shareholder’s basis should be reserved for those items that provide a formal exclusion from an economic benefit.

So going back to our numerical example, the shareholders were not entitled to increase their stock basis in the S corporation from $15 million to $241 million upon the making of the QSub election, because the nonrecognition of the C corporation’s $226 million gain under Section 337 did not constitute tax-exempt income, and thus did not necessitate a basis increase under Section 1367(a)(1). As a result, the shareholders subsequent sale of the S corporation stock triggered a $215 million gain, rather than an $11 million loss.

This ruling has important planning implications as well, as it confirms that S corporations may want to think twice before buying the stock of a corporation and then making a QSub election. In purchasing the stock, you will be paying for the net FMV of the underlying assets. If you then make the QSub election, the deemed liquidation of the newly purchased subsidiary will require the parent to take a basis in the subsidiary’s assets equal to their historical cost. With the decision in Ball, it is clear that the Service’s position is that no step-up will be afforded to parent’s shareholders for the unrecognized gain on the subsidiary’s liquidation.

To illustrate, if a corporation acquires the stock of a company with assets having a basis of $100 and a FMV of $1,000 by paying $1,000 and then immediately makes a QSub election, all the parent corporation will have to show for its $1,000 investment is assets with a depreciable basis of $100. The $1,000 it paid for the stock “disappears.”

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